Sunday, January 15, 2012

A Conservative columnist writing for Liberal readers and spewing bunk

I read Ross Douthat's column in the New York Times pretty regularly.  He's usually thoughtful, which I appreciate, although I frequently find myself in disagreement with him, such as here.  In this post I'm going to take him to task because in his most recent column, a snippet of which is below as is a link to the full piece, most of what he says is utter nonsense.

Devotees of Adam Smith might have a hard time seeing the conceptual problem.  They equate the generation of private profit with the creation of social benefit.   Most Conservatives revere Smith, and therein lies a big part of the problem, because this all seems tautological to them. One needs a different way to think about the issues, one where making private profit may lead to social good, but that is not a logical necessity.  For that one needs to admit the possibility that private profit and social harm can co-exist.

In neoclassical economics, that is possible in the presence of negative externalities: pollution, global warming, that sort of thing.  More recently Robert Frank has been writing about a Darwinian rather than Smithian approach to economic competition.  The Darwinian approach admits the possibility of a mutation creating advantage for the individual and hence it is likely to propagate, while that same mutation is deleterious for the species. 

One advantage of what Frank says is that when looking at individual actors we can focus on their own advantage as providing the motivation.  In other words, private equity firms were motivated by the ability to make a buck.  That was the goal.  The goal wasn't to save American industry from increased global competition.  Perhaps that was the consequence, but it certainly wasn't the goal.  I hope Conservatives and Liberals alike can agree that the individual motive in Capitalism is profit.

Having separated the individual motive from the good of the system, one must look for systemic reasons as to why the behavior is beneficial (or pernicious).  I'll advance several of those here.

Leveraged buyouts, which is what Private Equity firms such as Bain engage in, entail the embrace of certain risks.  One argument for why they may be systematically beneficial is that the economy may not be taking sufficient risk.  Risk averse individual players, even comparatively large firms, may go for the sure thing rather than take on additional risk.  Because of limited liability, the leveraged buyout affords the possibility of greater embrace of opportunities that have a big potential upside.  If each individual risk has a high expected return then in aggregate the taking on of more of such risk can lead to a big benefit socially.

However, the argument can also be made in reverse.  This is done, for example, in John Cassidy's book How Markets Fail.  Individual risks may have negative expected return, but via leverage the individuals taking the risk may be shielded from the downside.   Investors who are shielded from the downside risk may indeed have a preference for highly risky investments.  When this is the case it will be deleterious in aggregate, even when the risks are independent.  If those risk are highly correlated, this can be the source of bubbles, the result of which can be catastrophic.

Let's turn to a different, but related argument, attributed to Clayton Christensen. In this argument, highly successful firms become too wedded to their existing product lines.  Those products generate profit in the near term, but the products have limited shelf-life.  Upstarts, that provide offerings which are considerably poorer in quality at present, compete by selling to a certain fringe of the market that wants cheap stuff.  Over time the upstarts move down the learning curve and ultimately have product that is better in quality than the what the big guys provide, at which time they overtake the incumbents and become the dominant firms.  Then the cycle repeats.  There are some obvious examples that fit the bill.  In 1980 IBM was clearly the dominant computer firm and Microsoft was an upstart.  Before 1990, Microsoft had overtaken IBM.  IBM was primarily in the mainframe business.  Microsoft concentrated on software for the PC.  In 1980 the PC was exotic.  In 1990, it was ubiquitous.

The Christensen story is Darwinian in that many in 1980 couldn't predict the dominance of the PC ten years hence.  The Christensen story is also about product market competition.  That's where Schumpeterian "creative destruction" happens.  If Douthat and other Conservatives, want to argue that leveraged buyouts were necessary (and remain necessary) into the future, they have to argue that somehow the product market type of creative destruction wasn't working well.  A charitable reading of the Douthat column is that the product market version worked fine but the incumbents were all American firms while the upstarts were all foreign firms.  So we needed a different version of upstart to keep the success domestically. That different version is via the financial capital market.

This is a very troublesome story.  Note that in the Christensen story the upstarts can fail, and quite often they do fail.  New small businesses exit at a very high rate.  The upstarts succeed only when they get a toehold and then when they subsequently innovate faster than the incumbents.  Nobody knows ahead of time that the upstarts will do this.  And, near as I can tell, the private equity firms don't know either.  What they do know, via the acquired firm's balance sheet, is that the incumbent is profitable, so there is money that can be taken out of the venture.

Let me turn to a third systematic issue, one I discussed in my critique of the movie Inside Job.  That is to look at the indirect consequence of leveraged buyouts, which are to be found by looking at firms that are candidates to be acquired but that take defensive measures ahead of time to ward off acquisition.  A priori, those defensive measures could be socially beneficial or they could be socially pernicious.  It can go either way.  In that other piece I argued that the consequences were mainly pernicious.  The point is that hardly anybody can read a firm's balance sheet to understand its position in the medium term, let alone the long term.  This puts enormous pressure on the near term, generating good current earnings and ensuring that extends for the the next few quarters.  But that sort of myopia is deleterious to the long run health of the economy.  Further, it encourages bubble-like thinking by making it appear that high growth rates are achievable.

Still a different way to consider the systematic impacts is from the vantage of the Engineer versus the MBA in determining the direction for corporate America.  This tension clearly existed before LBOs came into existence.  A very good read on this point is David Halberstam's book, The Reckoning.  In his framing, company success can be measured (a) by how innovative it is or (b) by how healthy it's balance sheet looks.  Viewed this way, the LBO can be conceived as a power shift from the internal Engineers to external MBAs.  Again, this can be good or bad a priori.  The good part is easy conceptually.  Increasing the bottom line on the balance sheet makes things better.  The bad part is harder conceptually.  If the pernicious consequence is to be enabled as a possibility in our thinking, it must mean there are important aspects of what the firm does that either are not captured at all on the balance sheet or are horribly mismeasured on the balance sheet. The issues are illustrated nicely in Malcolm Gladwell's piece, Overdrive: Who Really Rescued General Motors.

Let me close by noting that David Brooks on the News Hour last Friday also concluded that private equity firms such as Bain have been good for the economy overall, even if in some instances the acquired firm has gone belly up.  Here I wish thoughtful Conservatives would recognize that first, they have a tendency to reach this conclusion and second, they are likely doing this with Smith or Schumpeter arguments that don't prove anything.  They have an opportunity now to make this debate much more informative because surely the attacks on Romney regarding Bain will persist and just as surely Conservatives want to defend Capitalism.  Neither of these are sufficient in themselves to make the case.  A more direct look at consequences is needed.

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